Turkey's Central Bank initiates measures to phase out Lira-protection scheme

Turkey's central bank has embarked on a series of measures aimed at scaling back the widely controversial lira-protection scheme, known as KKM, signaling a move towards more conventional monetary policies. This strategic pivot follows the recent trajectory of interest rate hikes and underscores Turkey's commitment to financial stability amidst economic challenges.

The central bank, in a pre-dawn announcement on Sunday, unveiled a multipronged approach to gradually phase out the KKM scheme. First and foremost, it declared the cessation of the specific targets that had been set for banks regarding the conversion of foreign-exchange deposits into the KKM scheme. Instead, the central bank has urged financial institutions to focus on transitioning existing KKM accounts into regular lira accounts, effectively discouraging the renewal of KKM participation among both businesses and individuals.

This shift in approach has been echoed by a complementary change in reserve requirement ratios for FX deposits. The central bank has taken the step of elevating these ratios, thereby compelling depositors to consider shifting their holdings into regular lira accounts. The confluence of these measures aims to alleviate the undue pressure on the central bank to foot the bill for lira depreciation costs tied to the KKM program.

The KKM scheme, initially introduced by President Tayyip Erdogan's administration in late 2021, was intended to arrest the freefall of the Turkish lira against major foreign currencies. However, the program had mushroomed in scale, with KKM accounts ballooning to an astounding $117 billion or approximately 3.1 trillion lira, equivalent to around 25% of the total bank deposits. This rapid expansion was fueled by the dramatic 68% plunge of the lira over the course of the past two years.

In an attempt to mitigate the financial ramifications of the KKM scheme, the central bank had reportedly disbursed an estimated 300 billion lira (equivalent to $11 billion) in the months of June and July alone, with additional costs projected to reach 350 billion lira for the current month, according to Reuters.

These sizeable expenditures had begun to strain the central bank's financial reserves, necessitating a recalibration of policy direction.

The lira's recent stabilization, which concluded last week with a record low exchange rate of 27.02 to the dollar, has facilitated a conducive environment for this policy transition. The government's recent electoral victory in May paved the way for a comprehensive reconfiguration of the economic leadership, including the appointment of a new finance minister and central bank chief. This leadership transition emboldened a comprehensive policy shift encompassing substantial rate hikes and a commitment to rectify prior economic regulations to counter inflation and stabilize the trade deficit.

The central bank's motivation for this decisive move revolves around bolstering macro financial stability through the strategic redirection of funds from the KKM scheme to lira deposits. The central bank has signaled its intent to embark on additional measures in the same vein to further fortify the country's economic foundation.

In conjunction with the KKM changes, the central bank has also readjusted reserve requirement ratios for FX deposits, a move designed to concurrently encourage higher deposit rates and curb the proliferation of KKM accounts.

Reuters cited Hakan Kara, former chief economist at the central bank and currently associated with Bilkent University, saying that the central bank is attempting to address multiple issues with these measures.

"Official interest rates could have been raised without engaging in these complex affairs," Kara said.